Tim Duy with a Fed Watch in anticipation of next week's FOMC meeting:
We are just over a week out from the next FOMC meeting, and there is little reason to believe that the Fed is ready to make a significant shift in policy. Indeed, market participants are looking for the Fed to hold firm throughout the summer. And while the weak GDP report will likely leave monetary policymakers a bit more wary of the downside risks to the forecast, it had enough positive points to leave Fed policy fundamentally unchanged.
According to the Wall Street Journal, the GDP report suggests that the “worst of the slowdown might be past and giving economists reason to predict faster growth in the months ahead.” In the wake of a paltry 1.3% gain, this sounds like something of a leap of faith, but I can sympathize with four points:
1. The negative read on exports is almost certainly an anomaly given signs of relatively strong global growth. Note that the last time exports were a drag on growth was way back in 2Q03.
2. Likewise, the drag from government spending was also likely an anomaly to be reversed next quarter.
3. Business spending rebounded to post a gain, albeit nothing to get warm and fuzzy about. Still, coupled with the improvement seen in the durable goods report, the view that business investment spending has bottomed is reasonable.
4. Final sales to domestic consumers posted a 2.0% gain, consistent with the reading from the previous two quarters and suggesting that the headline figure is overstating weakness.
On the downside, however:
1. It is tough to see consumer spending posting another strong gain in Q2 given the run-up in gas prices (note that Target reduced its already weak estimates of April’s same store sales).
2. It remains far too early to discount the risk that the housing slowdown will feed into a more broad-based downturn. And there is still that subprime mortgage issue floating around in the background.
3. It is premature to sound the all clear on business investment (see Calculated Risk).
For my part, this may represent the low in the cycle, yet I still anticipate persistent lackluster economic conditions in the US throughout this year. The strength of the consumer remains something of a surprise to me, as I would have expected the housing downturn and higher gas prices to have more of an impact on spending. For now, however, households have managed to come up with the additional spending power to sustain growth. I don’t see miracles in investment spending, but the weakness in this area does not appear to be the result of a liquidity crunch, leading me to believe that the slowdown is largely a temporary phenomenon. On a positive note, I cannot help but notice the strength in commodity prices, which, in addition to continued strength in the Baltic Dry Freight Index, suggest a considerable surge in global activity. Such strength is inconsistent with a US recession. So I remain near my position of recent months: The basic scenario that a housing downturn would presage weaker growth was correct; what remains to be seen is the pace and magnitude of that downturn, both of which continue to throw a wrench in the most bearish forecasts.
Is there something in the GDP report to change the path of monetary policy? Probably not, given that recent Fed speeches anticipated that Q1 would be relatively weak while holding onto the belief that activity will accelerate later this year. Turn first to San Francisco Fed President Janett Yellen’s speech last week. After reading the speech, thinking about it, then rereading it again, I concluded that Yellen does not have a strong conviction on the direction of the US economy (some might suggest mine is a charitable interpretation):
These and other recent developments have not dramatically changed my mainline forecast for the U.S. economy over the next year or so, but they have significantly increased the risks to the outlook, both for growth and inflation. While I’ve revised down my forecast for economic activity for the first half of 2007, I still expect to see a moderate pace in the second half of the year. At the same time, much of the news pertaining to the first quarter has been disappointing, and has raised the downside risk for growth. I continue to think that inflation is likely to edge down over the year, but, with labor markets appearing to have tightened further, rather than easing as I expected, the upside risks to this outlook have gotten bigger.
She is, if nothing else, clearly an economist: The economy might improve, it might not. Inflation may go down, it may not. (Actually, I understand her dilemma; the outlook is subject to a large number of cross currents at the moment.) The uncertainty on all sides of her forecast leave her committed to the current policy stance, steady rates with a tilt toward inflation risks. It doesn’t look like Q1 GDP, or March CPI, shifted her position much. From Bloomberg:
Yellen said the U.S. economy grew at a ''crawl'' in the first quarter, citing the 1.3 percent annual pace reported yesterday by the Commerce Department. U.S. growth should pick up by the end of this year, and the current slowdown may help reduce inflation, which is ''slightly elevated at this point.''
Fed Governor Frederick Mishkin shares Yellen’s baseline forecast while noting the heightened risks to growth and inflation, but adds this sanguine remark:
Since the spring of 2006, however, the expansion of the U.S. economy appears to have been undergoing a transition to a more moderate and sustainable pace. Although such a transition will no doubt be marked by some bumps in the road, it represents a desired macroeconomic rebalancing that over the longer run can help ensure sustained non-inflationary growth.
Weak Q1 growth would likely qualify as one of those bumps in the road, and suggests that Mishkin remains willing to hold tight through the current softness with an eye toward stronger conditions in the back half of this year. A pipe dream? Perhaps, but a pipe dream that keeps the Fed on hold through some unquestionably weak data.
Something that could shake the Fed from its slumber would be a more significant deterioration in labor markets – for that we will have to wait for Friday, although the recent trend in initial unemployment claims is not signaling significant weakness. Moreover, Yellen’s description of recent nonfarm payroll growth as “gangbusters” is another indication of how far the Fed’s expectations have fallen. Job growth numbers on the soft side of 100k do not have the same shock value on Constitution Ave. as in previous cycles. The fact that the labor market remains, by their definition, firm – for whatever reason – is enough to keep the Fed on the sidelines.
With solid job growth in mind, the productivity report won’t be pretty – with aggregate hours worked up 1.5%, something around a near flat reading for productivity would not be surprising – but both Mishkin and Yellen look confident that this reflects simply a late-cycle slowdown. Let’s keep our fingers crossed. Also interesting should be the ISM reads on manufacturing and services. Will the former reflect the pick up in durable goods orders?
On the inflation front, one would think that March’s 0.1% gain in core-CPI would come as a relief. But the Fed is not likely to take much comfort in a single data point; given their level of worry about the persistence of inflation during this cycle, they will likely need multiple months of slower inflation (absent a broad deterioration in labor markets), to sound the all clear. And note that the recent spike in energy prices will raise once again the specter of future pass-through to the core.
In short, economic weakness does not look to be prompting enough anxiety in the hallowed halls of the Federal Reserve to shift policy. Unless the data turns against the Fed quickly, we are looking at a whole lot of the same through the summer.